Money, bank credit, and economic cycles

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Money, bank credit, and economic cycles

  1. 1. MONEY, BANK CREDIT, AND ECONOMIC CYCLES SECOND EDITION
  2. 2. MONEY, BANK CREDIT, AND ECONOMIC CYCLES JESÚS HUERTA DE SOTO TRANSLATED BY MELINDA A. STROUP SECOND EDITION Ludwig von Mises Institute AUBURN, ALABAMA
  3. 3. First Spanish edition 1998, Dinero, Crédito Bancario y Ciclos Económicos, Unión Editorial, Madrid Copyright © 1998 Jesús Huerta de Soto Second Spanish edition 2002, Unión Editorial, Madrid Third Spanish edition 2006, Unión Editorial, Madrid Copyright © 2006, 2009 Jesús Huerta de Soto Money, Bank Credit, and Economic Cycles Translated from Spanish by Melinda A. Stroup First English edition 2006 Second English edition 2009 Cover design: Photograph by Guillaume Dubé of a series of arches in a cloister in Salamanca, Spain. Ludwig von Mises Institute 518 West Magnolia Avenue Auburn, Alabama 63832-4528 All rights reserved. Written permission must be secured from the publisher to use or reproduce any part of this book, except for brief quotations in critical reviews or articles. ISBN: 978-1-933550-39-8
  4. 4. v CONTENTS PREFACE TO THE SECOND ENGLISH EDITION . . . . . . . . . . . . . . . . . .xvii PREFACE TO THE FIRST ENGLISH-LANGUAGE EDITION . . . . . . . . .xxxi PREFACE TO THE THIRD SPANISH EDITION . . . . . . . . . . . . . . . . . .xxxiii PREFACE TO THE SECOND SPANISH EDITION . . . . . . . . . . . . . . . .xxxvii INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xli CHAPTER 1: THE LEGAL NATURE OF THE MONETARY IRREGULAR-DEPOSIT CONTRACT . . . . . . . . . . . . . . . . . . . . . . .1 1 A Preliminary Clarification of Terms: Loan Contracts (Mutuum and Commodatum) and Deposit Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 The Commodatum Contract . . . . . . . . . . . . . . . . . . . . .2 The Mutuum Contract . . . . . . . . . . . . . . . . . . . . . . . . . .2 The Deposit Contract . . . . . . . . . . . . . . . . . . . . . . . . . . .4 The Deposit of Fungible Goods or “Irregular” Deposit Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 2 The Economic and Social Function of Irregular Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 The Fundamental Element in the Monetary Irregular Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Resulting Effects of the Failure to Comply with the Essential Obligation in the Irregular Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Court Decisions Acknowledging the Fundamental Legal Principles which Govern the Monetary Irregular-Deposit Contract (100-Percent Reserve Requirement) . . . . . . . . . . . . .11
  5. 5. 3 The Essential Differences Between the Irregular Deposit Contract and the Monetary Loan Contract . . . .13 The Extent to Which Property Rights are Transferred in Each Contract . . . . . . . . . . . . . . . . . .13 Fundamental Economic Differences Between the Two Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Fundamental Legal Differences Between the Two Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 4 The Discovery by Roman Legal Experts of the General Legal Principles Governing the Monetary Irregular-Deposit Contract . . . . . . . . . . . . . . . . . . . . . . . . .20 The Emergence of Traditional Legal Principles According to Menger, Hayek and Leoni . . . . . . . .20 Roman Jurisprudence . . . . . . . . . . . . . . . . . . . . . . . . . .24 The Irregular Deposit Contract Under Roman Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 CHAPTER 2: HISTORICAL VIOLATIONS OF THE LEGAL PRINCIPLES GOVERNING THE MONETARY IRREGULAR-DEPOSIT CONTRACT . . . . . . . . . . . . . . . . . . . . . . .37 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 2 Banking in Greece and Rome . . . . . . . . . . . . . . . . . . . . . . . . .41 Trapezitei, or Greek Bankers . . . . . . . . . . . . . . . . . . . .41 Banking in the Hellenistic World . . . . . . . . . . . . . . . .51 Banking in Rome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53 The Failure of the Christian Callistus’s Bank . . . . . .54 The Societates Argentariae . . . . . . . . . . . . . . . . . . . . . .56 3 Bankers in the Late Middle Ages . . . . . . . . . . . . . . . . . . . . .59 The Revival of Deposit Banking in Mediterranean Europe . . . . . . . . . . . . . . . . . . . . . . . .61 The Canonical Ban on Usury and the “Depositum Confessatum” . . . . . . . . . . . . . . . . . . . .64 vi Money, Bank Credit, and Economic Cycles
  6. 6. Banking in Florence in the Fourteenth Century . . . .70 The Medici Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72 Banking in Catalonia in the Fourteenth and Fifteenth Centuries: The Taula de Canvi . . . . . . . . .75 4 Banking During the Reign of Charles V and the Doctrine of the School of Salamanca . . . . . . . . . . . . . . . . .78 The Development of Banking in Seville . . . . . . . . . .79 The School of Salamanca and the Banking Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83 5 A New Attempt at Legitimate Banking: The Bank of Amsterdam. Banking in the Seventeenth and Eighteenth Centuries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .98 The Bank of Amsterdam . . . . . . . . . . . . . . . . . . . . . . . .98 David Hume and the Bank of Amsterdam . . . . . . .102 Sir James Steuart, Adam Smith and the Bank of Amsterdam . . . . . . . . . . . . . . . . . . . . . . . . .103 The Banks of Sweden and England . . . . . . . . . . . . .106 John Law and Eighteenth-Century Banking in France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109 Richard Cantillon and the Fraudulent Violation of the Irregular-Deposit Contract . . . . . . . . . . . . . .111 CHAPTER 3: ATTEMPTS TO LEGALLY JUSTIFY FRACTIONAL-RESERVE BANKING . . . . . . . . . . . . . . . . . . . . . . . .115 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115 2 Why it is Impossible to Equate the Irregular Deposit with the Loan or Mutuum Contract . . . . . . . . . . . . . . . .119 The Roots of the Confusion . . . . . . . . . . . . . . . . . . . .119 The Mistaken Doctrine of Common Law . . . . . . . .124 The Doctrine of Spanish Civil and Commercial Codes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Contents vii
  7. 7. Criticism of the Attempt to Equate the Monetary Irregular-Deposit Contract with the Loan or Mutuum Contract . . . . . . . . . . . . . . . . . . . . . . . . . . .133 The Distinct Cause or Purpose of Each Contract . .134 The Notion of the Unspoken or Implicit Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139 3 An Inadequate Solution: The Redefinition of the Concept of Availability . . . . . . . . . . . . . . . . . . . . . . . . . . .147 4 The Monetary Irregular Deposit, Transactions with a Repurchase Agreement and Life Insurance Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155 Transactions with a Repurchase Agreement . . . . . .157 The Case of Life Insurance Contracts . . . . . . . . . . . .161 CHAPTER 4: THE CREDIT EXPANSION PROCESS . . . . . . . . . . . . . . . .167 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167 2 The Bank’s Role as a True Intermediary in the Loan Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .172 3 The Bank’s Role in the Monetary Bank-Deposit Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178 4 The Effects Produced by Bankers’ Use of Demand Deposits: The Case of an Individual Bank . . . . . . . . . . .182 The Continental Accounting System . . . . . . . . . . . .184 Accounting Practices in the English-speaking World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .194 An Isolated Bank’s Capacity for Credit Expansion and Deposit Creation . . . . . . . . . . . . . .200 The Case of a Very Small Bank . . . . . . . . . . . . . . . . .208 Credit Expansion and Ex Nihilo Deposit Creation by a Sole, Monopolistic Bank . . . . . . . . .211 viii Money, Bank Credit, and Economic Cycles
  8. 8. 5 Credit Expansion and New Deposit Creation by the Entire Banking System . . . . . . . . . . . . . . . . . . . . . . . .217 Creation of Loans in a System of Small Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .223 6 A Few Additional Difficulties . . . . . . . . . . . . . . . . . . . . . . .231 When Expansion is Initiated Simultaneously by All Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231 Filtering Out the Money Supply From the Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . .239 The Maintenance of Reserves Exceeding the Minimum Requirement . . . . . . . . . . . . . . . . . . . . . .242 Different Reserve Requirements for Different Types of Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . .243 7 The Parallels Between the Creation of Deposits and the Issuance of Unbacked Banknotes . . . . . . . . . . .244 8 The Credit Tightening Process . . . . . . . . . . . . . . . . . . . . . . .254 CHAPTER 5: BANK CREDIT EXPANSION AND ITS EFFECTS ON THE ECONOMIC SYSTEM . . . . . . . . . . . . . . . . . . . . .265 1 The Foundations of Capital Theory . . . . . . . . . . . . . . . . . .266 Human Action as a Series of Subjective Stages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266 Capital and Capital Goods . . . . . . . . . . . . . . . . . . . . .272 The Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 The Structure of Production . . . . . . . . . . . . . . . . . . .291 Some Additional Considerations . . . . . . . . . . . . . . .297 Criticism of the Measures used in National Income Accounting . . . . . . . . . . . . . . . . . . . . . . . . .305 2 The Effect on the Productive Structure of an Increase in Credit Financed under a Prior Increase in Voluntary Saving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .313 Contents ix
  9. 9. The Three Different Manifestations of the Process of Voluntary Saving . . . . . . . . . . . . . . . . . .313 Account Records of Savings Channeled into Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .315 The Issue of Consumer Loans . . . . . . . . . . . . . . . . . .316 The Effects of Voluntary Saving on the Productive Structure . . . . . . . . . . . . . . . . . . . . . . . .317 First: The Effect Produced by the New Disparity in Profits Between the Different Productive Stages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .319 Second: The Effect of the Decrease in the Interest Rate on the Market Price of Capital Goods . . . . .325 Third: The Ricardo Effect . . . . . . . . . . . . . . . . . . . . . .329 Conclusion: The Emergence of a New, More Capital-Intensive Productive Structure . . . . . . . .333 The Theoretical Solution to the “Paradox of Thrift” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .342 The Case of an Economy in Regression . . . . . . . . . .344 3 The Effects of Bank Credit Expansion Unbacked by an Increase in Saving: The Austrian Theory or Circulation Credit Theory of the Business Cycle . . . . .347 The Effects of Credit Expansion on the Productive Structure . . . . . . . . . . . . . . . . . . . . . . . .348 The Market’s Spontaneous Reaction to Credit Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .361 4 Banking, Fractional-Reserve Ratios and the Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .385 CHAPTER 6: ADDITIONAL CONSIDERATIONS ON THE THEORY OF THE BUSINESS CYCLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .397 1 Why no Crisis Erupts when New Investment is Financed by Real Saving (And Not by Credit Expansion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .397 x Money, Bank Credit, and Economic Cycles
  10. 10. 2 The Possibility of Postponing the Eruption of the Crisis: The Theoretical Explanation of the Process of Stagflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .399 3 Consumer Credit and the Theory of the Cycle . . . . . . . . .406 4 The Self-Destructive Nature of the Artificial Booms Caused by Credit Expansion: The Theory of “Forced Saving” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .409 5 The Squandering of Capital, Idle Capacity and Malinvestment of Productive Resources . . . . . . . . . . . .413 6 Credit Expansion as the Cause of Massive Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .417 7 National Income Accounting is Inadequate to Reflect the Different Stages in the Business Cycle . . . . . . . . . . .418 8 Entrepreneurship and the Theory of the Cycle . . . . . . . . .421 9 The Policy of General-Price-Level Stabilization and its Destabilizing Effects on the Economy . . . . . . . . . . . .424 10 How to Avoid Business Cycles: Prevention of and Recovery from the Economic Crisis . . . . . . . . . . . . . . . . .432 11 The Theory of the Cycle and Idle Resources: Their Role in the Initial Stages of the Boom . . . . . . . . . .440 12 The Necessary Tightening of Credit in the Recession Stage: Criticism of the Theory of “Secondary Depression” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .444 13 The “Manic-Depressive” Economy: The Dampening of the Entrepreneurial Spirit and Other Negative Effects Recurring Business Cycles Exert on the Market Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .456 14 The Influence Exerted on the Stock Market by Economic Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . .459 15 Effects the Business Cycle Exerts on the Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .467 16 Marx, Hayek and the View that Economic Crises are Intrinsic to Market Economies . . . . . . . . . . . . . . . . . .468 17 Two Additional Considerations . . . . . . . . . . . . . . . . . . . . . .474 Contents xi
  11. 11. 18 Empirical Evidence for the Theory of the Cycle . . . . . . . .476 Business Cycles Prior to the Industrial Revolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479 Business Cycles From the Industrial Revolution Onward . . . . . . . . . . . . . . . . . . . . . . . . .482 The Roaring Twenties and the Great Depression of 1929 . . . . . . . . . . . . . . . . . . . . . . . . . .487 The Economic Recessions of the Late 1970s and Early 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . .494 Some Empirical Testing of the Austrian Theory of the Business Cycle . . . . . . . . . . . . . . . . .500 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .503 CHAPTER 7: A CRITIQUE OF MONETARIST AND KEYNESIAN THEORIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .509 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .509 2 A Critique of Monetarism . . . . . . . . . . . . . . . . . . . . . . . . . . .512 The Mythical Concept of Capital . . . . . . . . . . . . . . .512 Austrian Criticism of Clark and Knight . . . . . . . . .518 A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money . . . . . .522 A Brief Note on the Theory of Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .535 3 Criticism of Keynesian Economics . . . . . . . . . . . . . . . . . . .542 Say’s Law of Markets . . . . . . . . . . . . . . . . . . . . . . . . .544 Keynes’s Three Arguments On Credit Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .546 Keynesian Analysis as a Particular Theory . . . . . . .553 The So-Called Marginal Efficiency of Capital . . . . .555 Keynes’s Criticism of Mises and Hayek . . . . . . . . .557 Criticism of the Keynesian Multiplier . . . . . . . . . . .558 Criticism of the “Accelerator” Principle . . . . . . . . .565 xii Money, Bank Credit, and Economic Cycles
  12. 12. 4 The Marxist Tradition and the Austrian Theory of Economic Cycles: The Neo-Ricardian Revolution and the Reswitching Controversy . . . . . . . . . . . . . . . . . .571 5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .576 6 Appendix on Life Insurance Companies and Other Non-Bank Financial Intermediaries . . . . . . . . . . . . . . . . .584 Life Insurance Companies as True Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586 Surrender Values and the Money Supply . . . . . . . .591 The Corruption of Traditional Life-Insurance Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594 Other True Financial Intermediaries: Mutual Funds and Holding and Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .597 Specific Comments on Credit Insurance . . . . . . . . .598 CHAPTER 8: CENTRAL AND FREE BANKING THEORY . . . . . . . . . . .601 1 A Critical Analysis of the Banking School . . . . . . . . . . . . .602 The Banking and Currency Views and the School of Salamanca . . . . . . . . . . . . . . . . . . . . . . . .603 The Response of the English-Speaking World to these Ideas on Bank Money . . . . . . . . . . . . . . . .613 The Controversy Between the Currency School and the Banking School . . . . . . . . . . . . . . . . . . . . . .622 2 The Debate Between Defenders of the Central Bank and Advocates of Free Banking . . . . . . . . . . . . . . . . . . . .631 Parnell’s Pro-Free-Banking Argument and the Responses of McCulloch and Longfield . . . . . . . .632 A False Start for the Controversy Between Central Banking and Free Banking . . . . . . . . . . . .633 The Case for a Central Bank . . . . . . . . . . . . . . . . . . .635 Contents xiii
  13. 13. The Position of the Currency-School Theorists who Defended a Free-Banking System . . . . . . . . .639 3 The “Theorem of the Impossibility of Socialism” and its Application to the Central Bank . . . . . . . . . . . . .647 The Theory of the Impossibility of Coordinating Society Based on Institutional Coercion or the Violation of Traditional Legal Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . .650 The Application of the Theorem of the Impossibility of Socialism to the Central Bank and the Fractional-Reserve Banking System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .651 (a) A System Based on a Central Bank Which Controls and Oversees a Network of Private Banks that Operate with a Fraction